George Akerlof, a Nobel Prize-winning economist, analyzed the theory of adverse selection – which occurs when an offer conveys negative information about what is

George Akerlof, a Nobel Prize-winning economist, analyzed the theory of adverse selection – which occurs when an offer conveys negative information about what is being offered. In the market for used cars, Akerlof posited that sellers have more information about the car’s quality than buyers. He argued that this leads to the death spiral of the market, and market failure. However, the market has developed solutions such as warrantees, guarantees, branding, and inspections to offset information asymmetry.

Transcript

[Narrator] The famous comedian Groucho Marx once said, [Groucho] "I don't want to belong to any club that would accept me as a member." [Narrator] Believe it or not, the economist George Akerlof won a Nobel Prize for analyzing when Groucho-type reasoning makes sense and what the consequences are. Groucho was using the fact that the club was offering him membership to infer something about the quality of the club. [Groucho] “Yeah, because it's not very exclusive.”

[Narrator] Akerlof analyzed the more general situation of adverse selection when an offer conveys negative information about what is being offered. Akerlof's famous example was the market for used cars. Suppose that used cars come in a variety of qualities. From the worst, the lemons, the cars that always are breaking down to the very best, the most reliable cars, the plums. The sellers know the quality of their car but suppose that the buyers can't tell which used cars are lemons and which are plums. Since the sellers have more information than the buyers, this is a model of asymmetric information.

Since the buyers can't tell the difference between a lemon and a plum, they won't be willing to pay more than what an average quality car is worth. But seeing that the buyers are only willing to pay for average quality, sellers of the highest quality cars, the plums, will exit the market. When the highest quality cars exit the market however, the average quality of car falls, which reduces the price the buyers are willing to pay even more. And that causes the sellers of the next highest quality used cars to drop out of the market as well. At the end of what is sometimes is called "the death spiral," the market collapses and buyers conclude, just like Groucho, that they wouldn't want to buy any car that is offered for sale.

Of course, in the real world the used car market is thriving. Some 40 million used cars are sold every year. More than three times the number of new cars. That doesn't mean the model is wrong. It means that over time the market has developed solutions to the asymmetric information problem. Solutions like inspections, CARFAX reports and certified pre-owned programs that offer buyers guarantees of quality. The Adverse Selection model also has implications far beyond the used car market, most importantly to understanding debates over health insurance, as we discuss in future videos.